Litigation and Investigation Risk: What Should Investors Expect in 2023?

As a private equity investor or venture capitalist, you’re constantly driving priorities such as value creation, deals, due diligence and performance improvement. These are crucial. However, those of us focused on litigation, forensics, and risk spend our days helping PE firms and funds clamber out of crisis. As we begin Q2, here are seven trends impacting private equity to consider tracking closely for the remainder of the year.

When you spend enough time in our team’s space, you quickly learn to view the entire PE ecosystem through the lens of risk. That’s because we’re frequently in “firefighting” mode, helping PE fund managers and large private investors manage through crises that range from financially punitive to starkly existential.

We regularly pause, put “prevention hats” on, and help our clients think ahead and avoid the litigation and investigative minefields that can destroy value in minutes. We looked back at 2022 and asked ourselves what we learned last year. Collectively, we agreed that 2022 may have signaled the start of a new era. Investor confidence in the integrity and stability of financial reporting took a step backwards last year. Here’s a link to that blog. What about this year and beyond?

Soaring interest rates, heightened volatility, lower valuations, a dry IPO market, regional bank volatility, and growing political polarization has led to a vicious cycle with a vortex of increased weaponization of issues across the board and, for many, reduced risk tolerance.

We haven’t figured out how to look around corners yet, but here are the trends we are watching closely – most of which are likely to drive a growing wave of litigation, disputes, regulatory enforcements, and investigations throughout 2023 and beyond.

1. Initial Public Offerings or Other Exits?

With respect to IPOs, 2022 was like “Waiting for Godot,” right? With Samuel Beckett’s elusive off-stage character never arriving. We’re intensely curious about, say, the next three IPOs. Who will be first out of the gate? How will they perform? Will these transactions unleash the buildup of delayed exits? Or will they fail to validate market demand for investment theses still in the wind? It’s too soon to answer those questions, but nevertheless, PE firms would be wise to get ahead of the IPO “window” reopening now and, if they haven’t already, begin their financial statement preparation, sell-side due diligence and other transaction readiness activities to ensure deal success and a smooth post-close integration experience on day one. Also, litigation and regulatory investigations will proceed related to the previously booming SPAC arena and will be followed very closely.

In fact, there is a lesson learned there to be sure – as my FTI Consulting colleague Todd Rahn will discuss in more detail in a later blog, the SPAC boom was riddled with companies prematurely closing de-SPAC deals, waking up with empty champagne bottles around them and immediately needing to pivot to living and breathing as a public company. Now is the time for PE Firms and their portfolio companies eyeing an IPO, or M&A deal, a growing trend which Todd will also touch on, to use this transition cycle to get ready – the best teams are made in the offseason.   

2. Shareholder Activism and ESG-Related Litigation and Investigations Will Continue and Increase

There is an awful lot we don’t know about risks related to environmental, social and governance (ESG) issues or the return on investment associated with such expenditures. Undoubtedly, some PE funds that kicked off in 2022 baked some level of ESG-related risk into their projections, but not all. In our “2022 look-back” blog, we pointed out that financial reporting requirements around ESG issues are in their infancy – but are likely to emerge in greater detail as the Securities and Exchange Commission’s (SEC), and others, expands disclosures and audit committees start or continue incorporating ESG matters into their discussions of fraud risk. We expect the pace of new ESG cases and investigations to meaningfully increase. These enforcement actions may, in turn, further enable ESG-related risk calculations and countermeasures for PE investments this year.

Don’t also forget about the activists. Activists have historically been quick to point out governance-related issues associated with their targets as an early step in their critique of poor performing companies. We have begun to see some campaigns that also bear upon environmental and social issues, though such campaigns come with the challenge of convincing investors that there are near-term returns associated with such a change in thesis.

PE firms on the other hand often have a somewhat longer-term time horizon for their investments where ESG investments can be more directly linked to improved returns as well as mitigating risks. When coupled with the fact that we continue to see several high-profile investors well known for their public activism shareholder activism move more investment dollars into PE-style investments, and some PE funds take public activist positions in publicly traded equities, the line quickly gets blurred on who is who. That, however, is not the case for regulators who care more about the underlying behaviors of a corporate entity than who owns and finances that firm. That is a risk that will be borne for PE firms and activist investors alike regardless of which strategy they are employing. You can learn more in our latest Q4 2022 FTI Consulting Activism Vulnerability Report here.

3. Complexity in Regulation, Financial Reporting and Disclosure Requirements

This topic is broader than we can fully cover in this blog, but several matters should be on your radar. One is the SEC’s adoption of final rules governing the clawback of erroneously awarded compensation. Note that the rules do not set aside exceptions for entities such as emerging growth companies, smaller reporting companies and foreign private issuers, nor does it matter if the (former) executive was involved in the alleged misstatement. Another is the Federal Trade Commission’s (FTC) new proposed rule banning noncompete clauses for workers. This proposal would let employees accept jobs from competitive firms or launch their own businesses in the same space. It would also result in a spectrum of legal challenges from entities intent on defending noncompete agreements as a legitimate business practice. A third tailwind driving increasing complexity and upcoming regulation-related litigation is the FTC’s new policy statement on “unfair methods of competition” enforcement, which will need to be taken into consideration during PE-backed company merger reviews and may have a considerable impact on the time-honored tradition of pursuing roll-ups as a means of value creation. These are just a few examples – make no mistake – regulators are more than just watching, and it does not appear they will be deterred by a few setbacks along the way.

4. New Crypto Reporting Requirements in the Wake of Collapses

It doesn’t take a crystal ball to see these coming. Consider how many crypto entities have imploded over the past 18 months or so. As we learn more about what has happened, expect more regulations and better crypto reporting requirements – particularly around issues such as reserve transparency, governance, and real-time reporting. Notwithstanding any forthcoming new rules, we should also anticipate a continued hot pace of new inquiries and investigations related to risky bets, poor bookkeeping, lack of disclosure, and even fraudulent behavior. The questions of “was it all lost” and “where did the money go…and when…and why?” will continue to resonate. Related litigation and investigations will be closely watched and play out over time.

5. Cyber, Privacy and Data Risks

This short overview would be incomplete without a strategic nod to cybersecurity risk and its potential impacts to any PE fund or firm. The consequences of an incident extend well beyond internal operations, assets and controls to litigation and penalties for regulatory failures. A prudent approach to cybersecurity readiness and response is imperative – before your legal, compliance, IT, communications, and operating teams have to reach out to us for cybersecurity incident response support.

All organizations face cybersecurity risk, but PE firms possess the added challenge of mitigating risks to their organization and to their portfolio companies, current and future, simultaneously. This emphasizes the importance of cybersecurity due diligence. By implementing a risk-based approach to cybersecurity within deal due diligence, PE firms can effectively plan for integration, establish a clear strategy for long term risk management, and ultimately ensure that value is delivered. Further, PE firms must go beyond traditional due diligence, which typically does not include elements like proper review of cybersecurity and data privacy vulnerabilities, IT organization and structure evaluation, application analysis, systems and infrastructure assessment, and IT costs review. Instead, cybersecurity due diligence best practices should not only include an assessment of the cybersecurity and data privacy maturity of the target, but should go beyond an assessment of staff and controls to understand technical vulnerabilities through external attack surface exposure assessment and penetration testing of internal infrastructure and critical applications. In addition, deep and thesis-based analyses with value-creation recommendations and one-time and run-rate cost models provide important value at a critical stage in the investment lifecycle.

Although separate from cybersecurity, opportunities and risks related to data will be an increasing important area. Due diligence powered by machine learning will be paramount in a time of value investing following a period of pent-up demand. Digitizing the diligence process as much as possible with tools to review contract documents and capture keywords in data format, for example, will enable deal teams to do their jobs more efficiently. Leveraging advanced analytics tools to mine, aggregate and analyze transactional, customer and product data will enable deal teams to perform more in-depth and effective due diligence.   

Meanwhile, as PE sponsors seek to mitigate potential recession impacts on their existing portfolios, bolstering a portfolio company’s data capabilities or revenue operations will take on ever more importance, especially when taking into consideration the number of companies reliant on platforms that struggle to produce financial and operational data on a timely basis. Deploying cutting-edge data analysis solutions using proven and sustainable analytic tools, machine learning concepts and forensically sound statistical testing where necessary will become commonplace among those winning in this space.

6. Private Equity will not be Left out of the Impact of Increasing Restructurings

Restructuring activity began this year with a head of steam, and recent instability in the regional banking sector has further increased the likelihood that this year will remain a busy one. While 2023 will almost certainly outpace 2022 in terms of restructuring activity, the wider impact of recent bank failures on Fed monetary policy and the financial sector’s prospects and business practices is unknowable at the moment. You can learn more here about this trend from my FTI Consulting colleague Michael C. Eisenband .

7. New Fault Lines in Energy Transition and Infrastructure Investment

Many investors may view this area as a safer bet. That is yet to be seen. Several factors, of course, have driven a surge of investments into private infrastructure funds. Steady cash flows. Optimism fueled by the current policy landscape and government’s infrastructure funding. Investor focus on ESG outcomes. And perceptions of a moderate risk and growth profile. The speed and uncertainty of the energy transition and the growing complexity of renewable and low-carbon projects is shifting the risk-and-return dynamics of key asset classes in unpredictable ways. Industry leaders and investors are facing challenges in providing real solutions to the decarbonization of existing assets and the intrinsic complexity in the development and management of new technologies. This, in turn, is exposing you as an investor to a raft of unforeseen costs if you don’t have robust and nimble asset management plans in place to correct course and preserve value. The energy transition opens investors to a new realm of risks and opportunities. The investors who focus on robust operations will be able to successfully foster the latter. As Asset Management and Operations will continue to be the catalyst for future value due to the sensitivities around implementing and managing new technologies. As energy continues to transition, and infrastructure investments surge, there will be both winners and losers and disputes and investigations will increase accordingly.

Litigation Risk and PE Investments in 2023: Benefit from Others’ 20/20 Hindsight

As 2023 continues to unfold, make a mental note to engage a forensics perspective before locking in new PE investments and in assessing risks in the portfolio. It’s just common sense. When you understand how other PE funds and firms ran headlong into high-stakes litigation, arbitration and compliance roadblocks, ditches and washouts, you find better, cheaper and safer roadmaps and detours surprisingly quickly.